Working Capital Review Case

You are the owner of Artic Wolf Snowmobiles. You manufacture and sell a large variety of snowmobiles and
related parts and equipment on a national basis. You are struggling with finances, even though you took a
Business Finance course in college. Respond to the following financial dilemmas. (Do not carry numbers over
from one problem to another.)

Artic Wolfs Working Capital Cycle looks like the following:

Cash

Accounts Receivable Inventory

Sales

Cash Management

1. You are trying to identify how your company can better manage cash. You know that companies try to speed
up collections as one way of managing cash. To do this, your bank has offered to set up a lockbox system.
You typically receive 1.5 million a day and could earn 9% on any funds freed up through faster collections.
If the lockbox system can save 2 days in the collection process, and the firms bankers will charge $200,000
per year to operate the lockbox system, is it worth it to establish the system?

1,500,000 daily collections x 2 days = 3,000,000 additional collections

Invested at 9% = 3,000,000 x 9% = $270,000 per year
If the cost is $200,000, then this is a good investment

Note: Remember the basic concept slow money going out and speed money coming in so your company has
access to cash.

Inventory
Artic Wolf is experiencing some inventory control problems. The Inventory Manager, Wanda, currently orders
50,000 windshields four times a year to handle the annual demand of 200,000 units. Each order costs $75. The
carrying cost is 10% and the purchase price is $150. There is a safety stock of 200 units.
a. Calculate the EOQ. (Round to the nearest whole number for the next problems.)
b. What is the average inventory?
c. Calculate the total annual inventory cost using EOQ (includes ordering costs and carrying cost.)

a. EOQ = 2SO = 2x200,000x75 = 1,414.20 = 1,414units ($15 carrying cost is 10% of $150 cost)
C 15

b.Ave Inventory ( EOQ/2 = 1414/2 = 707 ) + Safety Stock of 200 = 907

c. . Ordering Costs = 200,000 sales / 1414 EOQ ordering amount = 141 orders per year
 = 141 orders x $75 per order = $10,575

Carrying Costs = 907 ave inventory x $15 carrying cost = $13,605

Total Inventory Cost = 10,575 + 13,605 = $24,180*

Note: If you calculate total inventory costs when the company ordered 50,000 windshields four times a year, you would
find that the company was previously spending $378,300 on inventory. This is the beauty of EOQ!

Accounts Receivable
You have the following schedule for aging of accounts receivable:
Age of Receivables, April 30, 2011

(1) (2) (3) (4)

Month Age of Percent of Amount
of Sales Account Amounts Due

April 0-30 $ 33,088,000 __80______

March 31-60 1,544,000 __4______
February 61-90 1,133,000 __3______
January 91-120 5,702,000 __14______
Total receivables $41,467,000 100%*

*This may not equal 100% due to rounding

a. Fill in column (4) for each month.(Round to the nearest percentage)
b. If the firm had $189,000,000 in credit sales over the four-month period, compute the
average collection period. Average daily sales should be based on a 120-day period.
c. If the firm likes to see its bills collected in 30 days, should it be satisfied with the average
collection period?
d. Disregarding your answer to part c and considering the aging schedule for accounts
receivable, should the company be satisfied?

b. Ave collection period = A/R / ave daily credit sales = 41,467,000 / (189,000,000 /120) = 41,467,000 /
1,575,000 = 26.3 days
c. Yes
d. Yes, most accounts are collected within 30 days.

Financing Working Capital

We owe $40,000 to a supplier. The supplier has offered a trade discount of 2/10 n 30. You can borrow the funds
from either of two banks: First City Bank will loan the funds for 20 days at an interest rate of 8%; Upstart Bank
offers a discounted loan for 20 days at an interest rate of 6%.
a. What is the cost of failing to take the discount?
b. What is the effective interest rate on each of the loans?
c. Based on what you know about the bank loan cost and the trade discount cost, which alternative should you
follow?
d. If City Bank asked you to keep a compensating balance of 8% and you needed to walk out of the door with
$40,000, how much should you initially borrow?
e. A credit card offer has come in the mail that would allow you to get a one-time cash advance of $40,000 at a
cost of $2,600. You could make monthly payments for one year to pay off the advance. What is the
effective rate of interest for this offer? How does this affect your decision in question c?

a. Failing to take the discount = Discount % x 360

100% - Discount % Final due date Discount period

= 2% x 360
100% - 2% 30-10

=2% x 18 = 36%

b.114% and 112%

c.Dont borrow to take the discount. If you have to borrow to pay the bill, use Upstart
d.40,000/(1 8%) = $43,478.26 needed
e.12%. You would use the credit card to borrow early and pay the bill. (It costs you 12% to get the discount value of
36%. So you would definitely use the card and pay early.)

Credit Decision
Artic Wolf is considering extending trade credit to some customers previously considered poor
risks. Sales would increase by $100,000 if credit is extended to these new customers. Of the new
accounts receivable generated, 10 percent will prove to be uncollectible. Additional collection
costs will be 3 percent of sales, and production and selling costs will be 79 percent of sales. The
firm is in the 40 percent tax bracket.

a. Compute the incremental income after taxes.

b. What will Artic Wolfs incremental return on sales be if these new credit customers are
accepted?
c. If the receivable turnover ratio is 6 to 1, and no other asset buildup is needed to serve the new
customers, what will the companys incremental return on new average investment be?

a. Additional sales............................................................................................. $100,000

Accounts uncollectible (10% of new sales).................................................... 10,000
Annual incremental revenue.......................................................................... $ 90,000
Collection costs (3% of new sales)................................................................ 3,000
Production and selling costs
(79% of new sales)...................................................................................... 79,000
Annual income before taxes........................................................................... $ 8,000
Taxes (40%)................................................................................................... 3,200
Incremental income after taxes...................................................................... $ 4,800
 Incremental income
b. Incremental return on sales
Incremental sales
$4,800 / $100,000 4.8%

c. Receivable turnover = Sales/Receivable = 6x

Receivables = Sales/Receivable turnover
= $100,000/6
= $16,666.67
Incremental return on new average investment =
$4,800/$16,666.67 = 28.80%